Rule Number One: Don’t Invest in Something You Don’t Understand

It’s very easy to make money in today’s market. Unfortunately, it’s also very easy to incur future permanent losses if you don’t be careful. I’d like to go over a great way to adhere to Buffets Rule Number One: Don’t invest in something that you either don’t understand are aren’t familiar with.

A great example? Chinese micro-caps.

Not only do most Chinese companies report non-GAAP earnings (making their accounting practices fairly dubious), but they are also prone to a slew of other issues including rampant shareholder dilution, corrupt management, poor accounting practices, and cloudiness on what the company actually does.

Many Chinese companies have been rooted out as frauds over the past year or two but I’d like to highlight a case study on the dangers of Chinese micro-cap stocks. Hopefully you will learn what to look for and how to avoid permanent loss of capital.

Note: I’m not saying that you should avoid Chinese small-caps entirely, only that being comfortable and familiar with the business and it’s environment is even more imperative than with domestic firms. If you do have some knowledge of the space, other mistakes give you an even greater chance of producing some alpha.

Just take a quick look at their 10k statements and quarterly reports and some red flags immediatley come up. First let me give you a brief background on how this company was formed. If you get as lost as I did when reading it, that can’t be a good sign.

On April 22, 2006, following a Xinsheng shareholder meeting at which an attorney-in-fact was appointed to represent the Xinsheng shareholders, China Agri entered into a stock purchase agreement with the attorney-in-fact (the “Stock Purchase Agreement”). Pursuant to the Stock Purchase Agreement, China Agri issued an aggregate of 5,389,221 shares (10,950,897 shares after a 2.032-for-1 forward split in October 2006) of common stock to the Xinsheng shareholders in consideration of the execution of the Management Agreement between Xinsheng and Meixin. Pursuant to the Stock Purchase Agreement and a voting trust and escrow agreement (the “Voting Trust and Escrow Agreement”) entered into by the parties in connection with the Stock Purchase Agreement, these shares were issued in the name of the trustees for the Xinsheng shareholders, which trustees also act as the escrow and selling agent for the Xinsheng shareholders for the sale of the shares. The trustees are entitled to exercise all rights and powers to vote the shares on behalf of the Xinsheng shareholders. Each shareholder can request the release of his or her shares from the trust. Alternatively, each shareholder can request that the trustees sell the shares on behalf of such shareholder and remit the proceeds to such shareholder. The entry into the Management Agreement, the Stock Purchase Agreement and the Voting Trust and Escrow Agreement, and the appointment of the attorney-in-fact, were approved by the Xinsheng shareholders at a meeting held on April 10, 2006, in accordance with PRC Company Law. The issuance of China Agri stock to Xinsheng shareholders was made in reliance on the exemptions from registration under the Securities Act of 1933 provided by Regulation S and/or Section (4)(2). The Xinsheng shareholders are in the process of terminating the Voting Trust and Escrow Agreement effective December 2009.

Chinese small-caps are constantly merging, reverse-merging, and spinning off/buying different segments of their businesses. As you read above, it’s hard enough to understand how this company was even created nevertheless what they actually do.

Moving on in the report, we find that the company pays an odd amount for rent. CHBU's 10K report states that their rent is between 25-40 dollars per month. This seems odd for a $25 million dollar company.

In addition, I’ve been wildly unsuccessful in contacting the company to probe them on these concerns. They have no secretary, just an instant voice mail from proposed contact numbers given on press releases.

People will go on and on about how these companies are poised to explode. For CHBU in particular, I read in another article that it’s “numbers look great and they are in the proper growth market that will be further multiplied by high food inflation”.

I wonder if the author tried to go to their website, read its financial statements, contact management, try out their product, etc. Most likely not, but hey, the numbers look great right?

Moral of the story: Spend some time to get to know a company before you invest. Act like a business owner. Would you be confident running a business that has errors in your financial statements, doesn’t allow contact from investors, and has no legitimate proof of any underlying operations?

I didn’t think so.

About the author:

Ryan Vanzo

Ryan Vanzo has a Finance and Accounting degree from Bentley University with experience at multiple mutual funds doing fundamental research. His work has appeared in the Financial Post, Graphiq, The Motley Fool, Yahoo! Finance, GuruFocus, SeekingAlpha, and more.

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